Richard (Rick) Ferri is the founder and Managing Partner of Portfolio Solutions®, a registered investment adviser managing over $1.4 billion in client assets. He is responsible for research, education and directs the firm’s investments. Rick has over 25 years of experience in the industry including ten years as a financial consultant at two major Wall Street firms. He graduated from the University of Rhode Island with a B.S. degree in business and from Walsh College with an M.S. degree in finance, and also holds a Chartered Financial Analyst (CFA) charter. Rick has published extensively including several books on index funds, ETFs and asset allocation. He writes regularly for the Wall Street Journal, Forbes, the Journal of Financial Planning, and his own blog at www.RickFerri.com. Prior to entering the financial industry in 1988, Rick was an officer in the Marine Corps where he flew fighter aircrafts. He retired from the USMC reserves.

Million-Mile View Of Investment Value

Imagine we’re on an intergalactic spaceship traveling far away from Earth. It’s a quiet day. There are no meteor storms or alien encounters to contend with. We’re sitting in the Solar Lounge discussing a topic of great interest to both of us — the root elements of investment value. Our dialogue is as follows:

What defines investment value? Is it the return of an investment over time? We contemplate this and decide that return cannot be a good definition of value because inflation causes prices to rise, which is not an increase in real value. Then inflation gains are taxed by governments, which reduces real value.

Is investment value the real return less taxes over time? Perhaps, but it appears we’re missing something. Let’s take a step back and look at this question more broadly.

We agree that inflation and taxes must be discounted out when determining long-term value. We also agree that risk and return are joined at the hip; the greater the perceived investment risk in the short term, the higher the expected return in the long term.

It also appears universally true that taking risk tends to be rewarded by the government through a lower tax rate. Interest income on taxable bonds is paid as ordinary income while capital gains and dividends are taxed at a lower rate.

I recalled reading a study from 2013 by Elroy Dimson and Christophe Spaenjers entitled The Investment Performance of Art and Other Collectibles. This study interested me because the authors measured very-long-term investment returns for several asset classes. Their data spanned 112 years, from 1900 to 2012, well beyond the life expectancy of an individual at the time. Taxes were not part of their analysis.

Dimson and Spaenjers show that owning small slices of multiple businesses through the stock market is riskier and more rewarding than lending money for an income stream or stashing money in Treasury bills, gold and collectables. They also showed that the volatility of asset class annual returns was directly related to the long-term return, adding more evidence to the theory that risk and return are related.

Figure 1 illustrated the long-term relationship between risk and return graphically. The corrosive effects of transaction costs and taxes were not included. Also, the currency used in the study is British pounds, which has no effect on the point. I combined the three collectable categories, (Art,Stamps and Musical Instruments) in the figure using equal weight.

Our conversation turns to the interpretation of the data in Figure 1. First, we looked at each asset class individually to see what explains their risk and return characteristics. Second, we stepped back and looked at the data in its totality in an attempt to draw conclusions.

Over the period 1900-2012, art, stamps and musical instruments (violins) have appreciated at an average annual rate of 2.4%-2.8% in real returns. Collectibles have enjoyed higher annualized real returns than government bonds (1.5%), bills (0.9%) and gold (1.1%); however, their return was lower than equities (5.2%).

UK Treasury bills: Treasury bills issued by HM Treasury have 1-month, 3-month, 6-month and 12-month maturities. Treasury bills are considered a “risk-free” asset in that the probability of not being paid back is supposed to be risk-free. Since there is no perceived risk, there is a low expected real return before tax, and there is no expected real return after tax.

UK Government bonds: The value of bonds comes from the cash flow they generate and the terminal, or par, value. UK government bonds (or Gilts) used by Dimson and Spaenjers were long-term maturities. This created a meaningful volatility to term-risk, which is the price change that occurs when interest rates fluctuate. Significant excess volatility occurred during WWI, which had a major economic impact on the UK. This excess volatility did not occur in the US during the same period. Thus, it can be argued that the Standard Deviation of UK bonds as illustrated in Figure 1 is higher than it would have been otherwise.

Gold: The obsession with gold has existed for thousands of years. Reliable pricing data exists going back to ancient times. Gold does not pay interest or dividends and does not multiply. One ounce of gold does not become two ounces if left in a safe place. Thus, its value is derived solely from supply and demand. Figure 1 shows a real return of 1.1% from 1900 through 2012. All this real return was earned during a short period from 2008 to 2012. Prices have fallen about 20% since and I fully expect they will fall further as memories of the financial crisis fade, demand slackens and more gold is mined. Over the very long term, the price tracks the inflation rate.

Post Your Comment

Post Your Reply

Forbes writers have the ability to call out member comments they find particularly interesting. Called-out comments are highlighted across the Forbes network. You'll be notified if your comment is called out.